The Decadence of the People’s Car

So far, the Volkswagen scandal has played out according to a well-worn script. Revelations of disgraceful corporate behavior emerge (in this case, the German automaker’s programming of 11 million diesel vehicles to turn on their engines’ pollution-control systems only when undergoing emissions testing). Executives apologize. Some lose their jobs. Their successors promise to change the corporate culture. Governments prepare to levy enormous fines. Life goes on.

This scenario has become a familiar one, particularly since the 2008 financial crisis. Banks and other financial institutions have enacted it repeatedly, even as successive scandals continued to erode confidence in the entire industry. Those cases, together with Volkswagen's "clean diesel" scam, should give us cause to rethink our approach to corporate malfeasance.

Promises of better behavior are clearly not enough, as the seemingly endless number of scandals in the financial industry has shown. As soon as regulators had dealt with one case of market manipulation, another emerged.

The trouble with the banking industry is that it is built on a principle that creates incentives for bad behavior. Banks know more about market conditions (and the likelihood of their loans being repaid) than their depositors do. This secrecy lies at the heart of financial activity. Polite analysts call it “management of information.” Critics consider it a form of insider dealing.

Banks are also uniquely vulnerable to scandal because many of their employees are simultaneously behaving in ways that could influence the reputation, and even the balance sheet, of the entire firm. In the 1990s, a single Singapore-based trader brought down the venerable Barings Bank. In 2004, Citigroup’s Japanese private bank was shut down after a trader rigged the government bond market. At JPMorgan Chase, a single trader – known as “the London Whale” – cost the company $6.2 billion.

What these repeated scandals show is that apologies are little more than words, and that talk about changing the corporate culture is usually meaningless. As long as the incentives remain the same, so will the culture.

The Volkswagen case is a useful reminder that corporate wrongdoing is not confined to the banking industry, and that merely levying fines or ramping up regulation is unlikely to solve the problem. Indeed, it is one of the iron laws of corporate physics: For every regulation, there is a proportionate proliferation of innovations to circumvent it.

It should come as no surprise that there were incentives in the automobile industry to game the system. Everyone knows that actual fuel economy does not correspond to the numbers on the showroom sticker, which are generated by tests carried out with the wind blowing from behind or on a particularly smooth road surface. Similarly, anyone who has stood next to a diesel vehicle, even one proclaiming the virtues of “clean diesel,” could tell that it was smellier than cars powered by gasoline.

There are two important similarities between the scandals in the finance industry and at Volkswagen. The first is that large corporations, whether banks or manufacturers, are deeply embedded in national politics, with elected officials dependent on such firms for job creation and tax revenues. Volkswagen in particular is an icon of German manufacturing. Chancellor Angela Merkel has gone out of her way to support the company, as did her predecessor, Gerhard Schröder, who came to its defense in 2003, when the European Commission challenged the legality of its holding structure.

The second similarity is that both industries are subject to multiple regulatory objectives. Regulators may want banks to be safer, but they also want them to lend more to the real economy, which often means taking more risks. As a consequence, they impose rules that do not clearly push banks in one direction or the other.

The regulation of automobile emissions faces a similar problem. As regulators’ focus turned toward limiting global warming, there were tremendous incentives to manufacture vehicles that produced fewer greenhouse-gas emissions, even if that meant, as with diesel engines, emitting other gases and micro-particles that are much more harmful to humans in their vicinity. There was never a discussion of the tradeoff between limiting local pollution and fighting climate change.

As the Volkswagen crisis so vividly illustrates, we need more than corporate apology and regulatory wrist slapping. It is time for a sustained discussion about how to craft regulations that provide the proper incentives to achieve the objectives we truly desire: economic and social wellbeing. It is only when that discussion takes place that we will get the banks, cars, and other goods and services that we want.

Harold James is a CIGI Senior Fellow. He is Professor of History and International Affairs and the Claude and Lore Kelly Professor of European Studies at Princeton University.

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